Mortgage choice won’t slow foreclosure

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Dear Dr. Don,
We have two mortgages on our home. The first mortgage is for $400,000 and is a 30-year fixed-rate note at 5.8 percent. The second mortgage is for $100,000. It is an interest-only 5/1 adjustable-rate mortgage currently at 9 percent, with three years to go until it resets.

If I wanted to pay a little extra every month, would I be better off paying it for the second mortgage or the first? My guess is the second, but I wanted to double-check.

In considering this question, I also need to address what happens in the future if I cannot make payments (job loss, etc.) on either mortgage and the house ends up in foreclosure. In such circumstances, would I be better off having made extra payments on the first or the second mortgage?

I have heard a lot about paying the mortgage payments biweekly but have read that making an extra payment every year accomplishes the same thing. What are your thoughts?
— Mike Mortgages

Dear Mike,
If the house ends up in foreclosure, it won’t matter much which loan you chose in terms of making the additional principal payments. The house will be sold, and both lenders are made whole before you would see any money back from the sale.

Homeowners in the circumstances you describe sometimes decide not to make the payment on the second mortgage, hoping the second won’t foreclose. That’s especially true in markets where the appraised value of the home is less than the outstanding balance on the first mortgage, because the second doesn’t have anything to gain in foreclosure.

Before making additional principal payments on either mortgage, I’d suggest reviewing the status of your emergency fund. Building up a liquidity cushion to get you through a period of job loss could mean a lot more in hard times than aggressively paying down the mortgage. Generally, you’ll want three to six months worth of living expenses, including mortgage payments, in the fund.

Then, if you have the ability to make additional principal payments each month, work on paying down the second mortgage because of its higher interest rate. Your goal should be to minimize your total interest expense.

To that end, I’d love to see you attack the second mortgage, either with a cash-out refinancing of your first mortgage or by finding a more competitive rate on the second. You didn’t give the particulars as to what your home might appraise for or how much equity you have in the property, so I don’t know how realistic the refinancing scenario is for you.

I’m not a fan of biweekly mortgage payments. You can do as well on your own by making additional monthly payments. Bankrate’s “Mortgage calculator” can show you how the additional payments decrease the life of the loan, although it isn’t set up for interest-only loans.

Compare the result from that calculator to what you can achieve using Bankrate’s “Biweekly mortgage calculator.” If your total annual payments are about the same in both calculators, remember that additional monthly payments allow you to reduce the mortgage without the hassle, fees or binding contractual payments of the biweekly mortgage.

Read more Dr. Don columns for additional personal finance advice.